Surprise, Surprise

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Just as it seemed clear that the US labor market was gaining momentum, April jobs numbers came in far below expectations. Payrolls increased, but by much less than most analysts had expected. Importantly, the numbers for March were also revised down. Instead of a two million gain in jobs in the last two months, the government is now reporting a gain of a little more than half that. Within moments of the news, the data were being parsed. Is economic demand weaker than we thought? Or are people reluctant to come back to work while Covid-19 continues, many schools remain closed, and temporary unemployment benefits are making staying at home more attractive than returning to lower-paid jobs? Supply shortages are already causing problems in a number of sectors — think semiconductors, and the impact on auto manufacturers. Now a threat of fuel shortages looms with last week’s cyberattack on the largest fuel pipeline in the US. Colonial is scrambling to get back online, and emergency government legislation passed Sunday will temporarily alleviate pressures by allowing more road transport. But investors are left to worry whether inflation or slow recovery should be their main concern.
The honest answer is that no one knows for sure. The unemployment report was like a Rorschach test. Progressives pointed to the need for more government spending to keep the recovery on track, as laid out in President Biden’s two large new proposals. Conservatives worried that the government is taking away incentives with the extraordinary stimulus so far, pointing in particular at the additional $300 temporary benefit for unemployed workers. Some states decided to refuse the federal money for extra unemployment benefits, and tighten up work requirements. Financial markets took bad news on jobs as good news for equities and bonds, just as they had reacted badly earlier in the week when Treasury Secretary Yellen mentioned that a stronger recovery could mean rising interest rates. Yellen quickly backed off that remark. By the end of the week, equities hit new records.

A strong recovery is underway, notwithstanding the latest jobs news. But there will be twists and turns, as throughout the strange past year of the Coronavirus Recession. With recovery, there will eventually be higher inflation and higher interest rates. The question for investors is timing — and whether markets will be spooked by any shift by the Fed, however justified, away from the post-Global Financial Crisis (GFC) world of monetary ease. Central banks are engaging in a delicate maneuver, aiming to bring long-term inflation and inflation expectations back to target, but without allowing a sustained overshoot that could trigger accelerating wage-price inflation. Remember, “normalization” around higher interest rates and inflation is what the Federal Reserve and other major central banks have been wanting to achieve. That is why they called on governments to use fiscal policy more actively to support the economy. The monetary tools developed since the GFC — swelling central bank balance sheets, and rock-bottom, and even negative, interest rates — have still left inflation in developed markets stubbornly below target. For investors, the search for yield and long-term positioning continues. As has been especially the case for the last year and a half, RockCreek is mindful that thoughtful asset allocation, strong security selection, and maintaining sufficient flexibility will be key for this period.
Observations and takeaways for investors:
Supply versus demand — shortages of people or of jobs?

In many countries, particularly in Europe, governments prioritized employment and business survival with safety net support for existing jobs. In the US, fiscal support was much bigger, but it was mostly not tied to employment. That has made the jobs numbers particularly volatile for the past year.

The US public sector, including the Fed, supplied unprecedented liquidity to the financial sector to support markets, especially in March 2020 as the Treasury market almost seized up. Of the fiscal spend, some of it went to keep businesses from bankruptcy, and to encourage small businesses to protect staffing. But this was a much smaller effort than in Europe. Instead, much of the government money has gone directly to individuals and households, notably the three rounds of stimulus checks and temporary raises in unemployment benefits. That supported incomes even as unemployment shot up. Among lower-income families, the government support held spending up as well, even as millions of Americans lost their jobs. The April unemployment data confirm that there are still more than 8 million fewer jobs than pre-pandemic a year ago. Despite a steady decline in claims for unemployment benefits in recent weeks, claims remain higher than they were at any time during the GFC.

Meantime, easy money and expansionary fiscal policy have helped companies to avoid bankruptcy and finance themselves cheaply. Earnings have outperformed this year. Faced with these facts, the Administration and Democrats in Congress and outside are calling for swift passage of the rest of the Administration’s economic proposals. They see the April jobs numbers as reinforcing the need for more fiscal action, focused on supporting workers and families. Between the American Jobs Plan and the American Families Plan, President Biden has proposed spending an astounding $4 trillion over 10 years on infrastructure, defined quite broadly, and on further support for low-income families, child care, education and housing.

Many worry that this will overheat the economy. This is what underlies inflation concerns. Already, there are many reports of employers finding it hard to hire the workers needed to restart businesses, especially seasonal and service work. Earlier more restrictive immigration policies may be impacting labor supply also. A jobs mismatch is typical for the stage of the cycle, before firms adjust and push up wages. But governors in a number of states, now including Florida, Georgia, Montana, North Carolina, and Wyoming, blame overly generous unemployment checks and are tightening work requirements and, in some cases, taking the unusual step of refusing federal money. They do not want to add to employer woes by giving unemployed workers the additional $300 from the federal government on offer through September. Others point to research, such as that published by the NBER in February, that suggests the original $600 temporary unemployment benefits did not impact labor supply. However, we are in a different labor market now, as Jason Furman points out in a blog on the April data. Furman suggests that worker hesitancy may be a factor in holding back payrolls, but not only because of unemployment benefits. Reasons may include fears of Covid-19 — a Census pulse survey suggested that this may be a factor for as many as 4 million Americans who are reluctant to return to the workforce — and a need to care for children when schools are open only intermittently.

Although concerned about overheating, Republicans in Congress — as well as some moderate Democrats — do not like the proposals the President has floated to help pay for the new spending and thus reduce the impact on the deficit. There will be some compromise, perhaps in the form of smaller and more focused spending bills and almost certainly with a smaller increase in corporate income tax, and a lower rate for the global minimum tax. Compromise on capital gains tax increases are also likely. But the President believes that his stated policy — making the better off pay more for needed spending — is popular among Americans. Virginia may provide an early bellwether. As in all off-years, state-wide and county elections take place in November. By then, it will be clearer whether Congress has passed what the President asked for, and whether we are more worried about inflation or jobs.

What went down is coming back up — slowly

After this unusual recession, we are facing an unusual recovery — along a number of dimensions. Sectors that usually are hit during recession, from housing to manufacturing, have been shielded from the worst or, in the case of housing and construction, have seen booming conditions for much of the past year, with a continuous rise in house prices since last June. And the service sector that typically acts as a cushion — not just in the US but in many economies, including in emerging markets — was devastated by Covid-19 and lockdowns. Of course, real estate apart from housing has had a tough time as offices and retail malls emptied out, rents became harder to collect, and the pandemic dragged on. This in turn has hurt small businesses in the service sector of major cities. Empty offices mean no lunch-time crowds or after-work shoppers for the dry cleaners, coffee shops, small grocery stores and restaurants that thrive in good times, and usually hang on during recessions as office employees continue to come to work. The decisions of many businesses to continue remote working, even as more and more Americans are getting vaccinated, will delay recovery where offices are concentrated, often in city centers — including in the nation’s capital where many Federal government workers are not yet back in the office and nor are the international civil servants at the World Bank, IMF, InterAmerican Bank.

The impact of this recession on men and women and young and old has also been different from usual. This is partly linked to the sectoral impact described above, as women are overrepresented in services industries and men in manufacturing. It is also related to school closures and the disproportionate burden of childcare on women with young children. President Biden has emphasized the need to help women back into the workforce. The pandemic, and the forced closure of schools and daycare, have led many women to withdraw from the labor force, both in the US and elsewhere. This could inflict long-term and lingering damage on women and families, according to Oxfam. In the US, the female labor force participation rate remains 2.8 percent below its November 2019 number, according to the Minneapolis Fed.

Friday’s employment data showed that the US female labor participation rate remains depressed. Similarly, a recent study by the Central Bank of Korea showed working moms in South Korea have suffered far greater job losses than single women during a pandemic, which has hit female employment harder than in previous economic crises. Among women aged between 30 to 45, those who were married accounted for 95 percent of the reduction in female employment in the year through March 2021, according to Bank of Korea economists Oh Sam-il and Lee Jong-ha. That sets the pandemic apart from previous recessions when men typically suffered significant job losses, leading married women to stay in the job market to become family breadwinners. Single women saw a greater decline in employment than their married counterparts in earlier slumps, the study found.

And there is still Covid-19

Vaccinations are now clearly bringing down Covid-19 infections — where vaccines are available. In the US and some other countries in the West, hopes of a return to some semblance of normal life are almost palpable as vaccine rates rise and summer beckons. But even in the US, where the vaccine rollout has exceeded expectations and supplies are plentiful, public health officials are warning not to expect herd immunity. There remains vaccine hesitancy in many communities and virus variants continue to appear. What is a realistic hope is that infection is contained and serious illness, hospitalization and deaths are sharply lower, while people get used to having booster shots periodically. With that, the pandemic scare will likely fade.

For much of the world, especially in Asia, the situation is more worrisome. Vaccination rates are low, in part because of early success in curbing the virus with non-pharmaceutical interventions such as border closures, lockdowns and masking. In emerging markets, there are fears when a pocket of infection is detected of another deathly surge in the virus. India’s terrible plight is an object lesson.

So far, however, it seems that markets remain more worried about potential lockdowns than public health. This was the case in India once again last week, with equity markets showing incredible resilience in the face of the ongoing tragedy. Since the Indian government began to phase out its nationwide lockdown in May of 2020, Indian equities have enjoyed a sustained period of outperformance. The recent surge of Covid-19 cases has not convinced authorities to roll out another nationwide lockdown — the focus has been on localized measures and the markets seem satisfied with this solution. We also believe markets are pricing in India’s enviable position as a major producer and administrator of Covid-19 vaccines. Year to date, Indian equities are outperforming Chinese equities by over 500 bps in USD terms and emerging markets equities as a whole by over 100 bps.
Takeaways for Investors

Despite strong earnings, growth projections and economic momentum at least in the US, soaring valuations appear to be taking a toll on equity market sentiment. Given that the reopening trade has played out to a large extent, it is getting harder to see any “fat pitches” to take advantage of in the markets. Investors are looking carefully at shifting away from high-beta, low-quality stocks in favor of higher-quality, cash flow generative names in an effort to be defensively positioned. Following several months of underperformance relative to small-cap value, the mega-cap technology names are getting a fresh look.

There are growing concerns that we could see a pause or even a pullback from here given how high valuations have soared since the bottom in March of last year. According to data from Morgan Stanley, the US equity risk premium, a comparison of expected profits reflected in stock prices versus the 10-year US government bond yield, stood at around 4 percent prior to the pandemic and rose to as high as 6.9 percent as the economy went into full shutdown. Since then, it has shrunk considerably and been hovering at only around 2.9 percent. During the dotcom era and the lead-up to the GFC, US equity risk premia did get all the way to -2.8 percent and 1.3 percent, respectively. But that is of little comfort, given what those lows presaged.

Most economists are predicting US GDP will remain strong through 2021 but with the growth rate peaking in the second quarter. This is important since equity returns have historically been lackluster when strong economic growth first begins to slow. Peak growth typically coincides with ISM (average of Manufacturing and non-Manufacturing) PMI readings above 60, and the March and April figures came in at 64.7 and 60.7, respectively. Measuring from eight different peak dates going back to 1997, the average 3-month return for the S&P 500 Total Return following a peak is -1.6 percent. At six months it is +1.0 percent, and at 12-months it is +4.8 percent. The outcomes range widely however with an average standard deviation of returns across time periods of 7 percent. It is of course impossible to know a peak until it has passed, but with the non-manufacturing PMI recording its highest ever reading in March of this year, coinciding with the highest Manufacturing PMI reading since 1983, the reading is likely close to a local top.
The prospect of higher interest rates in the US spooked emerging markets investors last week. Although flows were still positive, (extending the inflow streak to 32 weeks), the net gain was marginal, coming in at $106 million compared to $2.3 billion the previous week. All regions saw a significant drop in interest. Friday’s job miss in the US may yet encourage renewed interest but last week served as a clear reminder that emerging markets assets remain vulnerable to US monetary policy.

As in the US, value and cyclical names have outperformed growth year-to-date. Demand for commodities, particularly base metals and crops continues to drive this trend, along with demand for cyclical technology sectors such as semiconductor manufacturers. Chinese demand for copper and iron ore has continued to lead to a surge in the price of both metals. The higher price of iron ore has also led to record high steel prices. At the same time, China’s grain demand is now breaking records. China has a sizable corn deficit as a result of livestock needs — it is trying to rebuild its domestic hog supply after a mass-culling due to swine flu — and China wheat imports for 2020-2021 are forecast to be the highest in 25 years. All this bodes well for major metals and grains exporters such as Brazil, Chile, and South Africa. It is no coincidence that all of these markets have enjoyed a strong rebound in asset prices recently.
RockCreek Update
For May, the RockCreek Book Club (RCBC) has selected Competition Demystified: A Radically Simplified Approach to Business Strategy by Dr. Bruce Greenwald. Stay tuned for next month’s pick!

Team RockCreek

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